Cutting Spending Now is the Wrong Strategy for Reducing the Fiscal Deficit

by Christian Proaño, Assistant Professor of Economics, and Laura de Carvalho, SCEPA Research Assistant

It is undeniable that the U.S. sovereign debt-to-GDP ratio should be reduced from its current level of nearly 95% over the medium-run. However, an overly hasty reversal of the U.S. fiscal stance based primarily on government spending cuts could be counterproductive given the fragile situation of the U.S. economy. In short, the main priority of the Obama Administration should be the consolidation of the nascent economic recovery.

There are two main arguments for a sharp reduction in government spending to restore fiscal sustainability, private investment, and economic growth...

The first is that reducing the government deficit automatically leads to an increase in private investment and economic growth. This is based on standard textbook theory, which suggests that an increase in government deficits increases demand for loanable funds. Given a constant supply of savings, this would lead to more competition for loans and, therefore, higher interest rates, which would reduce capital accumulation and economic growth.

The second argument is the alleged existence of a threshold level of government or sovereign debt beyond which investors (the so-called bond vigilantes) would fear the inability of the government to meet its debt obligations and would require higher bond yields. This threshold argument has been fueled by the empirical study by Reinhart and Rogoff (2010). Based on annual data for dozens of countries over nearly two hundred years, this study identifies a debt level of 90% of GDP as the threshold beyond which a country is likely to slide into a debt crisis.

These justifications for spending cuts should be qualified. Concerning the first argument, fiscal hawks usually (like to) overlook the fact that deficit reduction is not only achieved through spending cuts; increasing taxes is an equally good – or better – alternative. In fact, as discussed in the IMF World Economic Outlook (2010), the empirical evidence for a short-term positive impact on economic activity from spending cuts (provided by Alesina and Perotti (1995) and Alesina and Ardagna (2010)) does not consider the effects of other expansionary policies happening simultaneously, namely loose monetary policy and exchange rate depreciation. Given that U.S. interest rates are already near zero, the case for an expansionary effect from cutting spending is even weaker.

Further, as recently corroborated by the Congressional Budget Office (CBO, 2010), the tax multiplier is much lower than the government spending multiplier. A fiscal consolidation put forward primarily by tax increases (for high-income people and financial corporations, just to name a few meaningful alternatives) is less likely to affect the nascent and fragile economic recovery than the sharp spending cuts proposed by the GOP.

Concerning the second argument, Reinhart and Rogoff simply show that periods where levels of debt are higher than 90% of GDP tend to be characterized by lower average growth rates. However, they ignore the different directions of causality and the impact over time involved in the interaction between economic growth, deficits and debt. As revealed by the current experience of most countries, there is strong causality running the other way around: low GDP growth reduces revenues and increases spending, with the resulting larger fiscal deficits accumulating into high levels of public debt. Further, as argued by Irons and Bivens (2010), even if bond vigilantes exist, there is no theoretical justification for contemporaneous effects of higher debt on economic growth. Studies based on simple correlations between high debt levels and low economic growth rates are more likely to capture the reverse direction of causality. As a matter of fact, as discussed in De Carvalho, Proaño and Taylor (2010), empirical evidence shows that a deficit reduction is not only contractionary in the short-run, but may lead to higher debt-to-GDP ratios in the medium-run if it has a significant negative impact on economic growth.

We should remember that the sharp increase in the U.S. fiscal deficits - and therefore in the level of U.S. government debt - was not solely caused by the fiscal stimulus program. Due to the operation of automatic stabilizers, the severe downturn in economic activity substantially reduced government revenues and increased spending, also contributing to a higher fiscal deficit, as seen in Figure 1.

Proano Table


Figure 1. Real government revenues and expenditures as compared to private domestic components of effective demand (2007Q3=100)

Finally, the importance of timing for the effectiveness of fiscal policy shocks on economic activity has been corroborated by recent empirical studies using state-of-the-art nonlinear econometric techniques such as Mittnik and Semmler (2010), Fazzari et al. (2011), Baum and Koester (2011), among others. According to these studies, an expansionary fiscal policy shock (such as the implementation of a fiscal stimulus program) increases economic activity to a more significant extent if executed during recessionary periods. Following the same logic, the contractionary effect of an austerity plan would be even higher if the economy has still not fully recovered.

As the Greek example shows, implementing a restrictive fiscal policy based on sharp spending cuts can turn out badly if executed while the economic recovery is still not well established. In fact, it could entail serious dangers for the United States, in social as well as economic terms. For all these reasons, a reduction in government spending as put forward by the usual fiscal hawks would not improve public finances, but would instead mainly serve their political agenda of reducing the role of the government in the U.S. economy.

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